Problem: Suppose that a firm wants to raise 28 million dollars during the next year to be able to fund a significant expansion of its production facility. The share price is currently $60, and it pays a 1.00 dividend. The firm also has a somewhat higher debt ratio than other firms in its industry. The firm is currently generating $3.5 million per year net income, and the planned expansion is expected to generate additional net income of $3 million per year. However, the additional revenue will be zero in year 1 and 2, during set-up, and the annual additional revenue may vary by as much as 20% from the estimated each year. The firm has the following options for financing the project:
A. Issue common stock directly to the public. There are currently 985,000 shares outstanding. The new shares would be sold at $57 per share, with $2 per share under writing costs.
B. Alternatively, the firm could offer its current shareholders an opportunity to maintain their current | proportionate ownership. They would issue rights to shareholders to purchase these shares at $48 per share. The flotation costs of this offering would be approximately $1.00 per share.
C. Finally, the firm could issue 10-year, 5.50% non-convertible subordinated debentures. These would be issued at par, with a 2% commission being paid to the investment banker for underwriting and distribution services. There would be sinking fund requirement of $4.0 million per year, beginning in the fourth year.
Question: 1. As far as possible detail the issues associated with each choice of raising capital, in your discussion evaluate the following:
- Under option a, assuming the issue is fully subscribed, to raise the needed 28 million, what is the number of shares that need to be issued?
- Under option b, assuming the issue is fully subscribed, to raise the needed 28 million, what is the number of shares that need to be issued? What is the number of rights required to buy a share this plan?
- Will the firm be able to meet its interest, sinking fund, and dividend payments over the course of the next 10 years? Discuss this.
2. Discuss what the tax implications will be for the firm. How will these impact net income in each case?
3. What will the effect of each strategy be on the ability of the firm to raise capital in the future, should a new opportunity arise?